Banking StandardsWritten evidence from the New Economics Foundation


1. This submission is based on research carried out by nef over a number of years, and in particular draws on four publications:

Where Does Money Come From? A guide to the UK monetary and banking system (Sep 2011)

Quid Pro Quo: Redressing the privileges of the banking industry (Sep 2011)

Where Did Our Money Go? Building a banking system fit for purpose (Oct 2010)

The Ecology of Finance: An alternative white paper on banking and financial sector reform (Nov 2009)

These publications contain extensive references and so this submission has been kept clear of references and footnotes for the sake of brevity and readability.

2. Some observations in this submission also draw on the personal experiences of the authors of these reports who include a former investment banker in equities and corporate advisory at Barclays de Zoete Wedd and Credit Suisse First Boston, and a former investment banker in fixed income and derivatives at Goldman Sachs.

Executive Summary

3. The Commission’s call for written evidence refers to three main objectives set out in the policy document “Sound banking: delivering reform” that accompanies the draft Bill, namely:

making banks better able to absorb losses;

making it easier and less costly to sort out banks that still get into trouble; and

curbing incentives for excessive risk taking.

These three objectives were also set out in the reports of the ICB (Independent Commission on Banking) as being directed towards a broader aim “to create a more stable and competitive basis for UK banking”.

4. Although undoubtedly containing many provisions that are useful in themselves, we submit that the draft Bill fails to address the promotion of stability and competition in two key respects:

lack of recognition of the credit creation function of banks; and

failure to eliminate the “too-big-to-fail” subsidy enjoyed by large banks.

Both of these failings are highly material to both stability and competition, and also of significance to the conduct of banking activities.

The Credit Creation Function of Banks

5. There is no recognition within the ICB Final Report or the draft Bill of the role played by retail banks in supplying sterling bank deposits through the extension of credit and purchase of assets, and hence creating the bulk of the UK’s money supply. Instead reference is made to deposit-taking, which is an established phrase in regulation and describes part of what retail banks do. The far more significant role of banks is the creation of new bank deposits. A full explanation of this process is beyond the scope of this submission, but the selection of quotes below establish that this description is fully supported by central bankers and monetary economists:

By far the largest role in creating broad money is played by the banking sector… When banks make loans they create additional deposits for those that have borrowed.

Bank of England (2007)

Given the near identity of deposits and bank lending, Money and Credit are often used almost inseparably, even interchangeably…

Bank of England (2008)

Each and every time a bank makes a loan, new bank credit is created—new deposits—brand new money.

Graham Towers (1939), former Governor of the Bank of Canada

Over time… Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs.

European Central Bank (2000)

The actual process of money creation takes place primarily in banks.

Federal Reserve Bank of Chicago (1961)

In the Eurosystem, money is primarily created through the extension of bank credit… The commercial banks can create money themselves.

Bundesbank (2009)

When banks extend loans to their customers, they create money by crediting their customers’ accounts.

Mervyn King (2012)1

Banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries.

IMF (2012)2

6. It is relevant to note that this credit creation function does not feature in most general equilibrium models of the economy used by orthodox economists. Recent academic debate, for example within the Institute of New Economic Thinking, has begun to consider whether this was a factor in the seeming inability of many economists and economic models to predict the financial crisis, and is investigating the role of unconstrained or poorly managed credit creation in maintaining, or rather upsetting, financial stability.

7. The draft Bill would therefore appear to be built on an analytical framework that is incomplete at best, and flawed at worst. We argue that in this key respect the theoretical understanding of banking that underlies the Bill will come to be seen as obsolete. This has implications for, inter alia, arguments for splitting retail from investment banking, stability of the banking system (and indeed broader macro-economic stability) and distortions in the retail banking market that prevent fair and effective competition.

Separation of Retail and Investment Banking

8. The proposed ring-fence does not separate the activity of credit creation from investment banking. This perpetuates the existence of conflicts of interest that was illustrated vividly by the LIBOR rigging scandal; a deposit taking bank (whether retail or wholesale) with no proprietary trading would have had nothing to gain financially from manipulating the market. Furthermore, it permits the use of credit creation for speculative purposes, such as the trading of commodities and other financial instruments, by the proprietary trading activities of the bank. This creates incentives for excessive credit creation for speculative activities which would not exist if the function of credit creation was entirely separated from trading activities.

Economic and banking stability

9. The role of banks as creators of the money supply has profound consequences for macro-economic outcomes, such as output, inflation, employment and the balance of trade, and also for relative activity levels in different sectors of the economy, such as SME investment, consumption, commercial property, speculation in financial instruments and residential property.

10. The key points are that the existing system has the following features:

the quantity and quality of money supply is determined by the aggregate of banks’ credit decisions, which are driven by confidence, short-term liquidity requirements, and often perverse financial incentives;

it is therefore naturally pro-cyclical;

new money will tend to be over-allocated to non-GDP transactions, leading to asset price inflation, followed by a credit contraction which prompts recession; and;

this inherent instability in the money supply leads to greater general macro-economic instability than need be the case.

The failure of the draft Bill, and preceding ICB reports, to properly take account of these features hampers its effectiveness in preventing future banking crises or ameliorating their effects. The draft Bill thus cannot be said to satisfactorily address the promotion of banking stability.

11. By way of illustration, prior to the crisis, banks expanded the money supply by £496 billion in between 2004 and 2007; representing a 42% increase in broad money in just three years. Regulatory constraints such as capital adequacy and prudential regulation proved ineffective in preventing an increase in the supply of credit that was clearly out of all proportion to underlying productive economic activity.

12. In terms of sectoral allocation, in the decade from 1999 to 2009 the volume of lending to the commercial property sector (excluding construction of new buildings) more than tripled. Lending to this sector moved from being 60% less than lending to all other non-financial sectors to ending the decade 50% more than all these sectors combined. Commercial property is significant because it is prone to speculative bubbles and involves the trading of existing assets (economic rent-seeking) rather than the construction of new ones (wealth creation).

13. This experience, together with the economic history of many other countries and previous credit bubbles, shows the central importance of the quantity and allocation of credit creation to macro-economic and financial stability.

Distortion of Competition

14. The credit creation function leads to a distortion in fair and effective market competition. Banks with a high market share of transactional and savings deposit accounts have a liquidity advantage over banks with smaller shares, because a higher proportion of credit extended by large banks returns to them as deposits, reducing the relative quantity and cost of liquidity management compared with smaller banks.

The Too Big to Fail Problem

15. Proper recognition of the role of banks in creating the money supply highlights a paradox that is unique to the banking industry. The origination and allocation of the money supply is an important public good. One of the key functions of money is as a medium of exchange, and the supply of money must be sufficient to enable market exchanges to take place. The shrinkage of bank balance sheets is severely deflationary for the economy because it involves the withdrawal of money from circulation. Yet this public function is performed by private-sector commercial banks according to their own profit incentives. There is no good reason to expect the aggregate of these decisions to result in an optimal societal outcome.

16. This paradox is the underlying cause of what Mervyn King has referred to as moral hazard; that risks are effectively underwritten by the taxpayer. This happens in two ways. First, in order to prevent the sudden loss of confidence that can lead to a run on the banks, they are provided with a highly valuable deposit guarantee scheme that is effectively underwritten by taxpayers. This is compounded by the problem of institutions that are too systemically important to fail. The disruption not only to payments infrastructure but also to the supply of bank deposits that would result from a major bank failure is so great that the market assumes (rightly so given the experience of October 2008) that the government will always bail out a troubled bank. This is known as the “Too-big-to-fail” (TBTF) subsidy and estimates of the value of this implicit guarantee in the UK over the past five years, in terms of allowing banks access to cheaper capital, range up to £109 billion a year. Our calculation for 2010 was £46 billion for the largest four UK banks. The TBTF subsidy accrues almost entirely to the largest banks and acts as a significant distortion to market competition and a barrier to new entrants.

17. One of the aims of the draft Bill, in enacting the recommendations of the ICB, is to reduce the value of this implicit taxpayer guarantee. However, the failure to recognise the public utility function of banks as the creators of the money supply fails to identify one of the root causes of the implicit subsidy. We argue that the ring-fence should be relocated to fully divide licenced deposit-taking from investment banking (the Glass-Steagal division) for this and a number of additional reasons including better respecting the entirely different cultures and business models of each side of the industry, and to prevent market distorting cross-subsidisation.

18. However, the TBTF subsidy is not solved by separation. The economic impact of a bank failure, and hence the likelihood of a bail-out, is a function of its size and interconnectedness. As interconnectedness is also related to size, it can be seen that the key driver of the TBTF problem is how big the bank is. Hence Lehman Brothers had no retail banking activities but many large banking groups with retail banking activities had extensive direct or indirect counterparty exposures to Lehman, and so its failure caused major disruption to the banking industry. A banking industry comprising a handful of large retail banks with extensive exposures to a handful of investment banks would still be one in which all the large players of both types are too big to fail and will therefore attract the TBTF subsidy.

19. Instead, the key to solving the TBTF issue is to focus on size rather than function. As we have noted, the implicit taxpayer subsidy of banks’ funding costs arises only for the largest banks, and small banks derive no benefit from it. We argued in 2011 that the ICB was too quick to dismiss the question of size limits for retail banks, and we note the growing debate on the appropriate size of individual banks and the banking sector as a whole. While it is true that there is an international dimension to all banking regulation, and hence any action on size limits would be best applied throughout the G20, there may still be a case for investigating the cost-benefit trade-offs of applying such limits to UK domestic and domiciled banks even in the absence of international action. This need not impact on the competitiveness of London as an international financial centre, as this success has never been based on the promotion or protection of national champion banks.

20. The potential benefits of a more diverse banking system, comprising a greater number of smaller banks, are not limited to addressing the TBTF problem. More diverse systems display greater resilience to shocks. Evidence from Switzerland and Germany since the financial crisis reinforces this point. Both countries have a significant local retail banking sector comprising geographically focused smaller banks that are primarily depositor funded and concentrate on the needs of SMEs and personal customers. In both countries, lending to SMEs and individuals since the crisis by large international banks has shrunk in line with similar banks in the UK. However, in stark contrast to the UK, local retail banks in these countries have steadily increased credit provision to SMEs and individuals in line with their previous prudent expansion prior to the crisis. This has helped to insulate these economies from the financial crisis to a far greater extent than in the UK. The financial system is further strengthened by institutional diversity in ownership structure, sector expertise and customer focus as well as geographical focus and scale. This diversity is different from, and not delivered by, a focus on introducing large challenger banks who are similar in all substantive respects to the incumbents. The UK’s banking system was ultimately weakened by the demutualisation and consolidation of building societies and the acquisition of the Trustee Savings Bank by Lloyds. There are no provisions in the draft Bill that will stimulate the diversification of the banking sector to any material extent, and we consider this to be detrimental for stability, competition and banking conduct.

The Conduct of Banking—Risk and Reward

21. It has been widely observed that the TBTF problem leads to misaligned incentives for risk taking by banks. If profits accrue primarily to (senior) staff but when catastrophic losses occur these accrue to the taxpayer there is a clear incentive towards higher leverage and short-term speculative activity that carries high risks and rewards.

22. However, the structure of ownership is also significant in this regard, and provides an argument that has not been fully examined for separating different functions within investment banking. The divisions between advisory, execution and trading activities that existed before the Big Bang of 1986 not only served to prevent conflicts of interest, but also allowed the ownership structure of such firms to fully align risks and rewards for bankers. The equity structure of partnerships is far more effective in inducing prudent use of leverage than an institutional separation between managers who capture the returns, and shareholders (and taxpayers) who bear the risks. Corporate advisory services are not capital intensive and so are well suited to a partnership structure, as the legal and accountancy professions demonstrate. The same is true for execution-only broking services, and provision of advisory services to investors. It is the provision of market liquidity (market-making) and manufacture of derivative products that require sizeable balance sheets. The most appropriate funding structure for such activities is equity and wholesale debt (rather than retail deposits). It may be argued that if such activities were entirely separated from licenced deposit-taking banks then the effect would be to greatly reduce the scale of securities trading and manufacture of derivatives. If so, it may be argued in return that we should welcome this reduction as an appropriate realignment of risk and reward and return to appropriate scale of these activities.

The Conduct of Banking—Culture

23. We conclude with some observations about the culture of banking. Many have argued that the cultures of retail and investment banking are quite distinct and that cross-contamination is unhelpful to the conduct of both. A distinction is drawn between transactional versus relationship banking, with the former characterised as a feature of investment banking, and the latter a feature of retail banking. While we would support the need for separation of retail and investment banking to allow the culture of each to reflect the nature of the underlying business activities, we would also argue that the problem is not primarily that “transactional” investment banking culture has infected “relationship” retail banking culture. The problem is that the culture of both sides of the banking industry have swung too far away from long-term relationship banking to a short-term focus on profit-maximising today’s deal. This change has been just as discernible within investment banking where activity used to be driven to a greater extent by long-term relationships and personal reputation. What has happened is that a culture of trading, or, some might say, gambling, epitomised in the first instance by large trading led US firms, has infected a culture of client-driven advisory and execution of corporate and investment business.

24. The reasons for this are complex, but some are common to both industries and certainly include the tendency toward large size and centralisation of decision-making within banks, and the misalignment of incentives. Drawing authority, responsibility and accountability to customers away from client-facing frontline staff bears the danger of damaging customer service in any type of large organisation from banks to railways. However, the danger is particularly acute in banking because of the nature of the products. The market for banking products suffers from the major imperfection of “information asymmetry” where the customer is at a severe informational disadvantage to the seller. Hence, banking conduct cannot be improved by competition alone; regulatory intervention to maintain the safety and transparency of products is required for banking in a way that it is unnecessary for, say, clothes retailing or hairdressing. For this same reason, incentivising bank staff on sales rather than customer services is entirely inappropriate to many bank products and we welcome the shift within UK retail banks away from sales-based remuneration for branch staff. However, it may be argued that a more effective answer to the problem of information asymmetry than regulation is a combination of customer ownership and smaller scale, whereby the interests of bank staff and customers become much better aligned.

20 November 2012

1 King, M (2012) Speech given by Mervyn King Governor of the Bank of England to the South Wales Chamber of Commerce at The Millennium Centre, Cardiff, 23 October 2012. London: Bank of England

2 Benes, J and Kumhof, M (2012) The Chicago Plan Revisited. (IMF Working Paper WP/12/202) Washington: International Monetary Fund

Prepared 2nd January 2013